Wells Fargo Earnings and 'Green Shoots'

NEW YORK ( TheStreet) -- Years of weak economic and labor market growth put the term "green shoots" in the dustbin of lame clichés parroted on Wall Street. However, the phrase is now of central importance to the earnings and stock performance of Wells Fargo ( WFC), the nation's largest mortgage lender and fourth-largest bank by assets.

In 2009, as stock markets hit a financial crisis bottom, so-called "green shoots" of economic growth sprouted in analyst research notes and in the business media to explain a swift recovery in stock prices and particularly those of bank stocks such as Wells Fargo ( WFC) and JPMorgan ( JPM).

Green shoots were meant to signify a flowering of economic recovery in the U.S. from the wreckage left by the mortgage meltdown, the collapse of Wall Street and near-death experiences across the global economy. Some such as Nobel laureate Paul Krugman were decidedly skeptical.

As we now know, there has been below-trend gross-domestic-product (GDP) growth in the U.S. that is particularly weak coming out of a deep recession. The fall in the unemployment rate from generational highs, meanwhile, is largely attributable to workers leaving the labor force and not new job creation. In Europe, economic data continues to worsen and emerging market economies are beginning to show weakness.

Google Trendsdata now shows people are about as likely to search for "bamboo shoots" as "green shoots," Jeffrey Sherman, a DoubleLine Capital portfolio manager, noted on a recent investor call.

While Sherman's point was to highlight how investor misconceptions often carry the day on Wall Street -- for instance the current mania over the Federal Reserve's so-called "tapering" to its bond buying -- it is also worth pointing out terms can be premature or relevant at a later date.

In the case of Wells Fargo's fourteenth straight quarter of earnings growth, green shoots are finally germane to the San Francisco-based lender. In fact, a late arrival of green shoots in data on GDP growth, new business formation, mortgage applications and jobs are the only hope Wells Fargo has of growing its earnings in coming years, as interest rates rise from historic lows.

It is now time to reintroduce the term to investors banking on the notion Wells Fargo's shares can move materially higher from current post-crisis highs.

Green Shoots Are Dead

Sherman, the DoubleLine portfolio manager, highlighted on a July 9 conference call that discussion of green shoots in 2009 conflated a slowing in the worsening of the financial crisis with actual recovery.

Markets were rising and banking sector stocks doubled within a short period of time not because of imminent expectations of financial recovery, but because of clear signs the economy had stopped getting worse.

Such a scenario is called a "second derivative" on Wall Street. Basically, the term is used to state things got less bad today than they did yesterday, or vice versa.

Next time there is a financial crisis, sophisticated investors should focus on such rates-of-change over notions like a "bottom" or "recovery."

For Wells Fargo, much of its highly-touted post-crisis earnings growth can be explained using similar logic.

Without dramatically increasing revenues in recent years, the bank has been able to record a significant rise in profitability as credit quality among the over $1 trillion in loans and securities the bank holds on its balance sheet stopped declining and eventually recovered.

With each passing quarter, Wells Fargo seems to record over $500 million in gains from improvements to its $800 billion portfolio of mortgage, auto and commercial real estate loans. Investors would now have a hard time differentiating the quality of those loans from those made in 2006, before the housing market cracked the U.S. economy.

Prior to second-quarter earnings, meanwhile, Wells Fargo was sitting on over $11 billion in unrealized gains to its securities portfolio, helping the bank to shore up its balance sheet and capital ratios amid Fed stress testing and oversight on the payout of dividends.

As the Fed now considers easing its unprecedented efforts to hold long-term interest rates down, those such rate-of-change benefits will disappear as a factor driving Wells Fargo's earnings.

Long Live Green Shoots.

Put simply, Wells Fargo needs imminent green shoots of economic growth, mortgage demand and business hiring and for those plantlets to flower into a full-fledged recovery.

"Two years from now, if people are excited about Wells Fargo, it's going to be about the huge market share they have on Main Street," Bill Smead, Chief Investment Officer of Smead Capital, said in an interview ahead of the bank's earnings.

Smead sold Wells Fargo shares in late 2008 and early 2009 amid a worsening of the financial crisis and uncertainty over the government's intervention in the banking sector. In 2009, the fund rebuilt its position in Wells Fargo starting at about $17 a share on an expectation the bank could earn about $4 a share in a weak economy. Now Smead holds Wells Fargo shares on the belief earnings can move higher if a real recovery emerges.

After-tax profits of $7 a share and a stock multiple of 11 times earnings in a few years' time would drive similar stock gains to those posted from 2009 to present. If green shoots once again disappoint, however, Smead and a cohort of bullish Wells Fargo investors such as Warren Buffett would be in for a rough ride.

Wells Fargo, for its part, continues to make the case to investors its business is diversified enough to benefit from both an easing of the financial crisis and an incipient recovery.

Chief executive officer John Stumpf on Friday said the bank saw its strongest post-crisis housing market activity in the second quarter. Stumpf also reiterated a well-worn refrain that the bank is not dependent on any one of its businesses for growth.

For now, Wells Fargo's numbers when it comes to the U.S. economy are showing the barest of green shoots.

The bank's mortgage banking income was flat for the quarter at $2.8 billion, and its residential mortgage originations grew a paltry 2.6% to $112 billion. While deposits continued to grow, commercial mortgage loans declined in the quarter.

Overall, Wells Fargo's total loans grew 0.24% to $802 billion, a perfect sign for where the business stands heading into the second half of 2013 and 2014. Most lending businesses did post double-digit growth when compared to year-ago levels.

Stumpf, unsurprisingly, is of the belief the bank can improve upon its numbers, and he highlights that a complicated interplay between economic data and decisions by the Federal Reserve on interest rates will play to the bank's benefit.

If Warren Buffett asked shareholders to make the case for betting against his company, Berkshire Hathaway, the "Oracle of Omaha" would likely have a similar difficulty refuting Stumpf's optimism.

Wells Fargo has seen its market share across mortgage lending, retail deposits, wealth management and investment banking grow significantly in post-crisis years. It now is a far better barometer of the U.S. financial system -- Wall Street and Main Street -- than Citigroup ( C), once the world's largest bank by assets.

Financial moves like the bank's 30-cent quarterly dividend and its billions in annual share repurchases are also likely give Wells Fargo investors such as Buffett a margin of safety if the bank did underperform in coming quarters.

Beware Green Shoots?.

Sherman, the DoubleLine portfolio manager spoke of green shoots within the context of today's investor monomania with the Fed's tapering of bond purchases. In both instances, Sherman said, the hype will wind up proving to be a disappointment.

In fact, as a fixed income portfolio manager Sherman is betting on that fact and a belief weakness in the U.S. and global economies will constrain rising interest rates. A rate surge at the end of the second quarter led to the worst performance in bond markets since 1994.

While Sherman believes Fed taper talk will fizzle, his biggest risk actually may be a re-emergence of discussion about green shoots.

If you liked this article you might like

Citigroup boosted CEO Michael Corbat's pay to $23 million, even as the bank failed to meet the CEO's own profitability goal for a third straight year, and as it reported a full-year net loss of $6.2 billion due to the write-off of tax credits that management had touted as a competitive advantage.

Last week's market drop rattled investors with concerns about rising inflation and interest rates. Yet with the economy progressing at a slower pace than in past cycles, there's plenty of time left to profit from bank stocks like JPMorgan, Bank of America and Citigroup, typically among the biggest beneficiaries of economic growth, argues Sandler O'Neill.